Working Capital Estimation – Operating Cycle Method

Operating cycle method of working capital estimation is based on the duration of operating cycle. Longer the period of the cycle, bigger will be the working capital requirements. Operating cycle means the cycle of raw material to work in progress to finished goods to accounts payable and finally to cash. Operating cycle time is the time taken starting from raw material purchases to its conversion into cash.

How to calculate or estimate working capital using this method?

For calculating the working capital, we would need 3 important things and they have estimated cost of goods sold, operating cycle time, and desired cash levels. The time of cycle can be calculated using operating cycle formula.

Formula for calculating working capital requirement directly is as follows

Working Capital = {Estimated Cost of Goods Sold * (Operating Cycle/ 365)} +Desired Cash and Bank Balance

Calculating the total working capital will not suffice the purpose. How this working capital is formed is also important. It means each component of working capital will have to be known. For that, we would first need the activity level of the company under review. Let us see how to calculate each item of working capital below:

Raw Material (RM) Stock

The formula for determining the RM stock is mentioned below. RM and many other calculations are based on estimated production units and therefore it should be calculated with utmost accuracy.

Estimated Production Units * Per Unit Cost of RM * (RM Holding Period / 365 Days)

Work In Progress (WIP)

In calculating the WIP, special care has to be taken of the percentage of labor and overheads. These may vary depending on the stage of the product and completion percentage. We have taken the percentage for an example.

Estimated Production * {Per Unit Cost of — RM (100%) + Labor (50%) + Overheads (50%)} * (Work In Progress Period / 365 Days)

Finished Goods Stock

In Finished Goods workings, we have to know the cost of production with the help of the previous year cost sheets or budgeted cost sheets of the company’s products.

Estimated Production * Per Unit Cost of Goods Produced * (Finished Goods Holding Period / 365 Days)

Accounts Receivables

This calculation is simple and we just need to put the estimates and average collection period right.

Estimated Production * Selling Price * (Collection Period / 365 Days)

Accounts Payables

The calculation of accounts payable is similar but the major difference is of raw material cost. We take finished goods selling price in accounts receivable calculation whereas raw material cost in case of accounts payable.

Estimated Production * Per Unit RM Cost * (Payment Period / 365 Days)

Advantages and Disadvantages of Operating Cycle Method of Working Capital Calculations

The advantage is that it is a detailed method and based on the actual economic conditions prevailing in the market. It gives a detailed understanding of the business as well and it is precise compared to other methods. The disadvantage is that it is a lengthy process to arrive at a component-wise calculation of working capital. It needs a lot of estimate like estimated production, holding period of inventory, collection and payment period, etc. So, it is a risky matter. There are probable chances of going wrong in estimating these data and that may hurt the whole process. It is advisable to keep a cushion while estimating things on the darker side.

Other Methods for Estimating the Working Capital Requirements

Percentage of Sales Method

Regression Analysis Method

Last updated on : August 1st, 2017
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